Worldwide Regional Aircraft Leasing

Transcription

1 Worldwide Regional Aircraft Leasing 2010 Annual Report

2 TO OUR STOCKHOLDERS AeroCentury found 2010 to be a difficult but profitable year. The Company recorded $23.0 million in annual operating lease revenue, and posted its seventh consecutive year of positive earnings, recording $1.04 diluted earnings per share ($1.07 basic earnings per share). Two significant customers that leased five aircraft caused the major setback for the Company in Both airlines ceased operations and returned those aircraft to the Company resulting in a significant loss of anticipated rental and reserves revenue. At the time the aircraft were returned, the Company held over $12 million of non-refundable maintenance reserves that had been collected from the two customers and recorded as reserves income in prior years. However, the use of those reserves to perform maintenance required to prepare the aircraft for future customers resulted in maintenance expense, further decreasing net income. In December 2010 the Company added a new aircraft model to its portfolio with the acquisition of a Bombardier Dash-8-Q400. Currently the Company s portfolio consists of forty-four aircraft and three aircraft engines, and covers eight different aircraft types. Our customer base continues to consist exclusively of regional carriers - seventeen different regional airlines operating passenger flights in all parts of the world. Although global passenger traffic was higher in 2010 compared to 2009, which is good news, the regional market continues to have its ups and downs as regional airlines adjust their operations to yield sustainable profits from current demand levels. Nevertheless, we believe that the regional air carrier market has stabilized and the aircraft that constitute the Company s portfolio will continue to provide a financially and operationally efficient choice for these carriers. The Company has continued to focus on extending current leases and remarketing aircraft that have been or may be returned, while seeking judicious acquisitions. We appreciate your interest and support. Neal D. Crispin President and Chairman of the Board

3 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC FORM 10-K (Mark One) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2010 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: AeroCentury Corp. (Exact name of Registrant as Specified in Its Charter) Delaware (State or Other Jurisdiction of Incorporation or Organization) (IRS Employer Identification No.) 1440 Chapin Avenue, Suite 310 Burlingame, California (Address of Principal Executive Offices) Registrant s telephone number, including area code: (650) Securities registered pursuant to Section 12(b) of the Act: Title of each class Common Stock, par value $.0001 per share Name of each exchange on which registered NYSE AMEX Exchange Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes No Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T ( of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K ( ) is not contained herein, and will not be contained, to the best of registrant s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer Non-accelerated filer Accelerated filer Smaller reporting company

4 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No On March 17, 2011 the aggregate market value of the voting and non-voting common equity held by non-affiliates (based upon the closing price as of June 30, 2010) was $25,191,400. The number of shares of the Registrant s Common Stock outstanding as of March 17, 2011 was 1,543,257. DOCUMENTS INCORPORATED BY REFERENCE Part III of this Annual Report on Form 10-K incorporates information by reference from the Registrant s Proxy Statement for its 2011 Annual Meeting of Stockholders. Except as expressly incorporated by reference, the Registrant s Proxy Statement shall not be deemed to be a part of this Annual Report on Form 10-K. 2

5 Forward-Looking Statements PART I FINANCIAL INFORMATION This Annual Report on Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the Securities Act ) and Section 21E of the Securities Exchange Act of 1934, as amended ( the Exchange Act ). All statements in this Report other than statements of historical fact are "forwardlooking statements" for purposes of these provisions, including any statements of plans and objectives for future operations and any statements of assumptions underlying any of the foregoing. Statements that include the use of terminology such as "may," "will," "expects," "plans," "anticipates," "estimates," "potential," or "continue," or the negative thereof, or other comparable terminology are forward-looking statements. Forward-looking statements include: (i) Part I, Item 1, Business, the Company s statements regarding its belief that the Company can purchase assets at an appropriate price and maintain an acceptable overall on-lease rate for them; that the Company is able to enter into transactions with a wider range of lessees than its competitors; that the Company s cash flow should continue to be sufficient to cover its expenses and Subordinated Notes payments and provide excess cash flow; that the Company expects it will have sufficient cash flow, or borrowing availability under its credit facility, to fund unusually large maintenance expenses; that competition may increase if competitors who have traditionally neglected the regional air carrier market begin to focus on that market; that the Company has a competitive advantage due to its experience and operational efficiency in financing the transaction sizes that are desired by many in the regional air carrier market; that the Company has a competitive advantage because JMC has developed a reputation as a global participant in the regional aircraft leasing market; and that neither compliance with laws regulating discharge of greenhouse gas and/or aircraft noise regulations, nor remedial agreements or other actions relating to the environment, are expected to have, a material effect on the Company s capital expenditures, financial condition, and results of operations or competitive position; (ii) in Part II, Item 3, Legal Proceedings, the Company s statements regarding its belief that none of the current lessee collection litigation, if resolved adverse to the Company, is anticipated to have a material adverse effect on the Company s financial condition or results of operations; (iii) in Part II, Item 7, Management s Discussion and Analysis of Financial Condition and Results of Operations Results of Operations, the Company s statements regarding its belief that the Company will continue to incur significant maintenance costs in order to prepare five aircraft for re-lease; (iv) in Part II, Item 7, Management s Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources, the Company s statements regarding its belief that it will continue to be in compliance with its New Credit Facility covenants; that the Company does not anticipate that the higher margin under the New Credit Facility will have a significant impact on the Company s results; that the Company will have adequate cash flow to fund operational needs and payments required under the New Credit Facility and the Subordinated Notes and that this belief is based on reasonable assumptions; that the amount of maintenance expense incurred to prepare certain aircraft for re-lease will be lower in 2011 than in 2010; that two Fokker-50 aircraft are expected to be delivered in the second quarter of 2011; that a Dash-8-Q400 is expected to be delivered in April 2011; and that the Company expects to purchase an aircraft in 2011 for which a deposit was made in 2010; (v) in Part II, Item 7, Management s Discussion and Analysis of Financial Condition and Results of Operations Outlook, the Company s statements regarding its belief that the Company will experience lower on-lease utilization rates and that the Company will experience longer lead times for remarketing of returned aircraft, as well as lower rental rates for remarketed aircraft; that the Company expects significant expense to be incurred when the maintenance work on aircraft returned in 2010 is completed in 2011; that the Company does not anticipate early returns of aircraft in 2011; that the balance of maintenance costs for aircraft returned in 2010 is approximately $4,600,000 and will likely be incurred in the first half of 2011; that the Company believes that the reserves received during the term of the leases and retained at the time the aircraft were returned will be sufficient to fund such maintenance; that two Fokker-50 aircraft are expected to be delivered in the second quarter of 2011; that a Dash-8-Q400 is expected to be delivered in April 2011; and that the four deferral agreements that were signed in 2009 and 2010 do not represent a trend that will result in additional deferral agreements in 2011; (vi) in Part II, Item 7, Management s Discussion and Analysis of Financial Condition and Results of Operations Factors that May Affect Future Results, the Company s statements regarding its belief that it will have sufficient cash funds to make any payment that arises due to any collateral base limitations; that most of the Company s current and expected growth is expected outside of the United States; that the availability under the New Credit Facility will be sufficient to fund projected acquisitions through the end of 2011; that the overall industry experience of JMC s personnel and its technical resources should permit the Company to effectively manage such new aircraft types and engines; that there are effective mitigating factors against undue compensation-incented risk-taking by JMC; and that the costs of complying with environmental regulations will not have a material adverse effect on the Company; and (vii) in Part II, Item 8, Financial Statements, the Company s statements regarding its belief that future taxable income will be sufficient 3

6 to realize the tax benefits of all the deferred tax assets on the balance sheet; that it expects to deliver two Fokker-50 aircraft to a new lessee in the second quarter of 2011; and that it expects to deliver a Dash-8-Q400 to a lessee in April These forward-looking statements involve risks and uncertainties, and it is important to note that the Company's actual results could differ materially from those projected or assumed in such forward-looking statements. Among the factors that could cause actual results to differ materially are the factors detailed under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Factors That May Affect Future Results," including the impact of the current economic downturn on the Company s customer base of regional air carriers and the current lessees of the Company, in particular; the compliance of the Company's lessees with obligations under their respective leases including rental deferral agreements; risks related to use of debt financing for acquisitions; the Company s success in finding appropriate assets to acquire with such financing; deviations from assumptions regarding maintenance cost on returned aircraft and that future major maintenance expenses will be relatively evenly spaced over the entire portfolio; and future trends and results which cannot be predicted with certainty. The cautionary statements made in this Report should be read as being applicable to all related forward-looking statements wherever they appear herein. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to the Company as of the date hereof, and the Company assumes no obligation to update any forward-looking statement or risk factor. You should consult the risk factors listed from time to time in the Company's filings with the Securities and Exchange Commission. 4

7 Item 1. Business. Business of the Company AeroCentury Corp., a Delaware corporation incorporated in 1997 (the Company, as defined below) acquires used regional aircraft and aircraft engines for lease to foreign and domestic regional carriers. Financial information for AeroCentury Corp. and its wholly-owned subsidiary, AeroCentury Investments VI LLC ( AeroCentury VI LLC ), which was dissolved in September 2009, (collectively, the Company ), is presented on a consolidated basis. All intercompany balances and transactions have been eliminated in consolidation. The business of the Company is managed by JetFleet Management Corp. ("JMC"), pursuant to a management agreement between the Company and JMC (the Management Agreement ), which is an integrated aircraft management, marketing and financing business and a subsidiary of JetFleet Holding Corp. ("JHC"). Certain officers of the Company are also officers of JHC and JMC and hold significant ownership positions in both JHC and the Company. The Company is engaged in the business of investing in used regional aircraft equipment leased to foreign and domestic regional air carriers and has been engaged in such business since its formation. The Company s principal business objective is to increase stockholder value by acquiring aircraft assets and managing those assets in order to provide a return on investment through lease revenue and, eventually, sale proceeds. The Company strives to achieve its business objective by reinvesting cash flow and using short-term and long-term debt and/or equity financing. The Company s success in achieving its objective depends in large part on its success in three areas: asset selection, lessee selection and obtaining financing for acquisition of aircraft and engines. The Company typically acquires additional assets in one of three ways. The Company may purchase an asset already subject to a lease and assume the rights and obligations of the seller, as lessor under the existing lease. Additionally, the Company may purchase an asset from an air carrier and lease it back to the seller. Finally, the Company may purchase an asset from a seller and then immediately enter into a new lease for the aircraft with a third party lessee. In this last case, the Company typically does not purchase an asset unless a potential lessee has been identified and has committed to lease the asset. Occasionally, the Company may also acquire an asset for which it does not have a potential lessee. The Company generally targets used regional aircraft and engines with purchase prices between $3 million and $10 million, and lease terms less than five years. In determining assets for acquisition, the Company evaluates, among other things, the type of asset, its current price and projected future value, its versatility or specialized uses, the current and projected availability of and demand for that asset, and the type and number of future potential lessees. Because JMC has extensive experience in purchasing, leasing and selling used regional aircraft, the Company believes it can purchase these assets at an appropriate price and maintain an acceptable overall on-lease rate for the Company s assets. In order to improve the remarketability of an aircraft after expiration of the lease, the Company focuses on having lease provisions for its aircraft that contain maintenance payments and return conditions such that when the lessee returns the aircraft, the Company receives the aircraft in a condition which allows it to expediently re-lease or sell the aircraft, or receives sufficient payments from the lessee over the lease term to cover any maintenance or overhaul of the aircraft required to bring the aircraft to such a state. When considering whether to accept transactions with a lessee, the Company examines the creditworthiness of the lessee, its short and long-term growth prospects, its financial status and backing, the experience of its management, and the impact of pending governmental regulation or de-regulation of the lessee s market, all of which are weighed in determining the deal terms offered to the lessee. In addition, where applicable, it is the Company s policy to monitor the lessee s business and financial performance closely throughout the term of the lease, and if requested, provide assistance drawn from the experience of the Company s management in many areas of the air carrier industry. Because of its hands-on approach to portfolio management, the Company believes it is able and willing 5

8 to enter into transactions with a wider range of lessees than would be possible for traditional, large lending institutions and leasing companies. The Company has funded its asset acquisitions primarily through debt financing supplemented by free cash flow. The primary source of debt has been a credit facility. The Company s previous $80 million credit facility (the Former Credit Facility ), which was collateralized by all of the assets of AeroCentury Corp., was to expire on March 31, 2010, but was extended by written amendments to April 30, On April 28, 2010, the Former Credit Facility was replaced with a new, two-year $75 million credit facility (the New Credit Facility ) provided by a syndicate of banks, with Union Bank, N.A. as agent. On June 4, 2010, the New Credit Facility was increased to $90 million, with the addition of a new participant bank s commitment of $15 million. An additional $14 million in debt financing was raised through the issuance of 16% senior unsecured subordinated notes ("Subordinated Notes") in 2007 and 2008, due December 30, 2011, the proceeds of which were used to pay down amounts previously borrowed under the Credit Facility. The Company has previously financed several asset acquisitions with lenders through asset-based term loans using special purpose subsidiaries. The Company believes that its current cash position, cash generated through operations, and unused credit available under the New Credit Facility will be sufficient to meet the Company s needs through the next twelve months. Working Capital Needs The Company s portfolio of assets has historically generated revenues which have exceeded the Company s cash expenses, which consist mainly of management fees, maintenance expense, interest payments, professional fees, insurance premiums and, beginning in April 2009, principal payments of the Subordinated Notes pursuant to an amortization schedule. The Company's management fees payable to JMC are based upon the size of the asset pool. Maintenance costs for off-lease aircraft and costs funded by non-refundable reserves are recognized as an expense as incurred. Interest expense is dependent on the outstanding balances of the Company s indebtedness, which has increased under the Former Credit Facility and New Credit Facility, and decreased under the Subordinated Notes as the Company has made principal payments pursuant to an amortization schedule. Professional fees are paid to third parties for expenses not covered by JMC under the Management Agreement. Insurance expense includes amounts paid for directors and officers insurance, as well as product liability insurance and aircraft hull insurance for periods when an aircraft is off lease. So long as the Company succeeds in keeping the majority of its assets on lease and interest rates do not rise significantly and rapidly, the Company s cash flow should continue to be sufficient to cover these expenses and Subordinated Notes payments and provide excess cash flow. If the Company incurs unusually large maintenance expense in any given period, the Company expects it will have sufficient cash flow, or borrowing availability under its credit facility, to fund such maintenance. Competition The Company competes with other leasing companies, banks, financial institutions, and aircraft leasing partnerships for customers who generally are regional commercial aircraft operators seeking to lease aircraft under an operating lease. Management believes that competition may increase if competitors who have traditionally neglected the regional air carrier market begin to focus on that market. Because competition is largely based on price and lease terms, the entry of new competitors into the market, particularly those with greater access to capital markets than the Company, could lead to fewer acquisition opportunities for the Company and/or lease terms less favorable to the Company on new acquisitions, as well as renewals of existing leases or new leases of existing aircraft, all of which could lead to lower revenues for the Company. The Company, however, believes that it has a competitive advantage due to its experience and operational efficiency in financing the transaction sizes that are desired by many in the regional air carrier market. Management believes that the Company also has a competitive advantage because JMC has developed a reputation as a global participant in the regional aircraft leasing market. 6

9 Dependence on Significant Customers For the year ended December 31, 2010 the Company had five significant customers, which accounted for 16%, 12%, 12%, 11% and 11%, respectively, of operating lease revenue, aggregating 62% of operating lease revenue. Concentration of credit risk with respect to lease receivables will diminish in the future only if the Company is able to lease additional assets or re-lease to new customers assets currently on lease to significant customers. Environmental Matters Neither compliance with federal, state and local provisions regulating discharge of greenhouse gas emissions (including carbon dioxide (CO2)) in the environment and/or aircraft noise regulations, nor remedial agreements or other actions relating to the environment, has had, or is expected to have, a material effect on the Company s capital expenditures, financial condition, and results of operations or competitive position. Employees Under the Company s management contract with JMC, JMC is responsible for all administration and management of the Company. Consequently, the Company does not have any employees. Available Information The headquarters of AeroCentury Corp. is located at 1440 Chapin Avenue, Suite 310, Burlingame, California The main telephone number is (650) The Company is subject to the reporting requirements of the Securities Exchange (the Exchange Act ). Therefore, the Company files periodic reports, proxy statements and other information with the Securities and Exchange Commission (the SEC ). Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 100 F Street N.E., Washington, D.C or by calling the SEC at (800) SEC In addition, the SEC maintains an Internet site ( that contains reports, proxy and information statements and other information regarding issuers that file electronically. Item 2. Properties. As of December 31, 2010, the Company did not own or lease any real property, plant or materially important physical properties. The Company maintains its principal office at 1440 Chapin Avenue, Suite 310, Burlingame, California However, since the Company has no employees and the Company s portfolio of leased aircraft assets is managed and administered under the terms of the Management Agreement with JMC, all office facilities are provided by JMC. At December 31, 2010, the Company owned one Bombardier Dash-8-Q400, eight Bombardier Dash-8-300s, two dehavilland DHC-8-100s, three dehavilland DHC-6s, fourteen Fokker 50s, two Saab 340As, six Saab 340Bs, seven Fokker 100s, and three General Electric CF34-8E aircraft engines which are on lease or held for lease. Item 3. Legal Proceedings. The Company is not involved in any material legal proceedings. The Company from time to time engages in ordinary course litigation relating to collection matters against defaulting lessees. None of the current lessee collection litigation, if resolved adverse to the Company, is anticipated to have a material adverse effect on the Company s financial condition or results of operations. 7

10 PART II Item 5. Market for Registrant s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. The shares of the Company s Common Stock are traded on the NYSE AMEX exchange ( AMEX ) under the symbol ACY. Market Information The Company s Common Stock has been traded on the AMEX since January 16, The following table sets forth the high and low sales prices reported on the AMEX for the Company s Common Stock for the periods indicated: Period High Low Fiscal year ending December 31, 2011: First quarter through March 16, 2011 $24.00 $15.35 Fiscal year ended December 31, 2010: Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal year ended December 31, 2009: Fourth Quarter Third Quarter Second Quarter First Quarter On March 16, 2011, the closing stock sale price on the NYSE AMEX exchange was $16.11 per share. Number of Security Holders According to the Company s transfer agent, the Company had approximately 2,400 stockholders of record as of March 1, Because many of the Company s shares of common stock are held by brokers and other institutions on behalf of beneficial stockholders, the Company is unable to estimate the total number of beneficial stockholders represented by those record holders. Dividends No dividends have been declared or paid to date. The Company has no plans at this time to declare or pay dividends, and intends to re-invest any earnings into the acquisition of additional revenue generating aircraft equipment. The terms of the New Credit Facility and Subordinated Notes prohibit the Company from declaring or paying dividends on its Common Stock, except for cash dividends in an aggregate annual amount not to exceed 50% of the Company's net income in the immediately preceding fiscal year so long as immediately prior to and immediately following such dividend the Company is not in default under the New Credit Facility and Subordinated Notes Agreement. Stockholder Rights Plan In December 2009, the Company s Board of Directors adopted a stockholder rights plan granting a dividend of one stock purchase right for each share of the Company s common stock outstanding as of December 18, 2009 and the Company entered into a rights agreement dated December 1, 2009 in connection therewith. The rights become exercisable only upon the occurrence of certain events specified in the rights agreement, including the acquisition of 15% of the Company s outstanding common stock by a person or group in certain circumstances. Each right allows 8

11 the holder, other than an acquiring person, to purchase one one-hundredth of a share (a unit) of Series A Preferred Stock at an initial purchase price of $97.00 under circumstances described in the rights agreement. The purchase price, the number of units of preferred stock and the type of securities issuable upon exercise of the rights are subject to adjustment. The rights expire at the close of business December 1, 2019 unless earlier redeemed or exchanged. Until a right is exercised, the holder thereof, as such, has no rights as a stockholder of the Company, including the right to vote or to receive dividends. Item 6. Selected Financial Data. This report does not include information described under Item 301 of Regulation S-K pursuant to the rules of the SEC that permit smaller reporting companies to omit such information. Item 7. Management s Discussion and Analysis of Financial Condition and Results of Operations. Overview The Company owns regional aircraft and engines, which are typically leased to customers under triple net operating leases. The Company defines an operating lease as a lease with a term that is less than the useful life of the asset. A triple net operating lease is an operating lease under which, in addition to monthly rental payments, the lessee is generally responsible for the taxes, insurance and maintenance and repair of the aircraft arising from the use and operation of the aircraft during the term of the lease. The acquisition of such equipment is generally made using debt financing. The Company s profitability and cash flow are dependent in large part upon its ability to acquire equipment, obtain and maintain favorable lease rates on such equipment, and re-lease or sell equipment that comes off lease. The Company is subject to the credit risk of its lessees, both as to collection of rental payments and as to performance by lessees of their obligations to maintain the equipment. Since lease rates for assets in the Company s portfolio generally decline as the assets age, the Company s ability to maintain revenue and earnings is primarily dependent upon the Company s ability to acquire and lease additional assets. The Company s principal cash expenditures are for management fees, maintenance expense, interest payments, professional fees, insurance and principal payments of the Subordinated Notes pursuant to an amortization schedule. The most significant non-cash expenses include aircraft and engine depreciation and, in some years, impairment provisions, which are affected by significant estimates, and amortization of costs associated with the Company s Subordinated Notes, which is included in interest expense. Critical Accounting Policies, Judgments and Estimates The Company s discussion and analysis of its financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities at the date of the financial statements. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, the Company s operating results and financial position could be materially affected. The Company s significant accounting policies are described in Notes 1 and 3 to the consolidated financial statements. The Company believes that the most critical accounting policies include the following: Aircraft Capitalization and Depreciation; Impairment of Long-lived Assets; Maintenance Reserves and Accrued Costs; Accounting for Income Taxes; and Revenue Recognition, Accounts Receivable and Allowance for Doubtful Accounts. 9

12 a. Aircraft Capitalization and Depreciation The Company s interests in aircraft and aircraft engines are recorded at cost, which includes acquisition costs. Since inception, the Company has purchased only used aircraft and aircraft engines. It is the Company s policy to hold aircraft for approximately twelve years unless market conditions dictate otherwise. Therefore, depreciation on aircraft is initially computed using the straight-line method over the twelve-year period to an estimated residual value based on appraisal. The Company estimates the period over which it will hold aircraft engines based upon estimated usage, repair costs and other factors, and depreciates them to their appraised residual value over such period using the straight-line method. The amount of the depreciation expense recognized by the Company during any accounting period with respect to a particular asset depends upon the estimated holding period over which such asset is depreciated. The Company periodically reviews plans for lease or sale of its aircraft and aircraft engines and changes, as appropriate, the remaining expected holding period for such assets. Estimated residual values are reviewed and adjusted periodically, based upon updated appraised residual estimates and the expected holding periods. Decreases in the market value of aircraft could affect not only the current value, discussed above, but also the estimated residual value. A reduction in the estimated residual value of an asset results in an increase in the amount of depreciation expense recognized by the Company during the remaining holding period of the asset. b. Impairment of Long-lived Assets The Company reviews assets for impairment when there has been an event or a change in circumstances indicating that the carrying amount of a long-lived asset may not be recoverable. In addition, the Company routinely reviews all assets for impairment annually. Recoverability of an asset is measured by comparison of its carrying amount to the future estimated undiscounted cash flows (without interest charges) that the asset is expected to generate. Estimates are based on currently available market data and independent appraisals and are subject to fluctuation from time to time. If these estimated cash flows are less than the carrying value of an asset at the time of evaluation, any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. Fair value is determined by reference to independent appraisals and other factors considered relevant by management. Significant management judgment is required in the forecasting of future operating results that are used in the preparation of futures estimated undiscounted cash flows and, if different conditions prevail in the future, material write-downs may occur. No impairment provision was recorded in 2010 or c. Maintenance Reserves and Accrued Costs Maintenance costs under the Company s triple net operating leases are typically the responsibility of the lessees, and the majority of the Company s leases require the payment of monthly maintenance reserves. Maintenance reserves and accrued costs in the accompanying consolidated balance sheets include: (i) refundable maintenance payments billed to lessees, which are paid out as related maintenance is performed or at the end of the lease, (ii) for lessees that pay non-refundable maintenance reserves, estimated maintenance costs accrued at the time a reimbursement claim or sufficient information is received regarding maintenance work performed, and (iii) maintenance for work performed for off-lease aircraft, which is not related to the release of reserves received from lessees. Non-refundable maintenance reserves are reflected as revenue based on reported usage, if collectibility is reasonably assured. The Company uses the direct expense method, under which maintenance costs are expensed as incurred. Maintenance reserves are set by mutual agreement of the Company and its lessee at inception of the lease and are based on the Company's estimate of the total maintenance cost at some future point resulting from the lessee s usage. Reserve rates are typically subject to an annual adjustment provision that accounts for inflation of maintenance costs. If a lessee is required to repair a component during the lease or perform a repair at lease end in order to comply with aircraft return conditions, it will be entitled to collect the reserves related to that repair from the Company, and any excess costs would then be the responsibility of the lessee. Therefore, if maintenance rates do not accurately reflect the true cost of a repair, the Company will not incur any financial impact. If, however, the Company repossesses an aircraft upon a lessee default, the Company would incur expense for the entire cost of the maintenance. If maintenance rates under a defaulted lease inaccurately reflect the costs of the lessee's usage, such costs would be in excess of collected reserves. It is also possible that, in order to remarket a repossessed aircraft, 10

13 certain inspections and repairs may need to be performed earlier than otherwise required by the manufacturer or regulatory specifications. In such a case, the collected reserves from the defaulted lessee, which were established assuming a normal interval between repairs, would likely be insufficient to cover the total cost incurred by the Company. In 2009 and 2010, several aircraft were returned to the Company prior to their respective lease expirations. The Company incurred significant maintenance expense as a result of the returns, and, in some cases, the maintenance reserves retained by the Company at the time of the returns were insufficient to cover the required maintenance. d. Accounting for Income Taxes As part of the process of preparing the Company s consolidated financial statements, management is required to estimate income taxes in each of the jurisdictions in which the Company operates. This process involves estimating the Company s current tax exposure under the most recent tax laws and assessing temporary and permanent differences resulting from differing treatment of items for tax and accounting principles generally accepted in the United States of America ( GAAP ) purposes. These differences result in deferred tax assets and liabilities, which are included in the consolidated balance sheet. Management must also assess the likelihood that the Company s deferred tax assets will be recovered from future taxable income, and, to the extent management believes it is more likely than not that some portion or all of the deferred tax assets will not be realized, the Company must establish a valuation allowance. To the extent the Company establishes a valuation allowance or changes the allowance in a period, the Company reflects the corresponding increase or decrease in the tax provision in the consolidated statements of operations. As discussed in Notes 1 and 8 to the consolidated financial statements, the Company measures and discloses the amount of its unrecognized tax positions. The Company had no valuation allowances or material unrecognized tax positions in 2010 or Significant management judgment is required in estimating the Company s future taxable income for purposes of assessing the Company s ability to realize any benefit from its deferred taxes. If actual taxable income is less than these estimates or if the Company adjusts its estimates of future taxable income, the Company may not realize any benefit from its deferred tax assets and its operating results and financial condition could be materially affected. e. Revenue Recognition, Accounts Receivable and Allowance for Doubtful Accounts Revenue from leasing of aircraft assets is recognized as operating lease revenue on a straight-line basis over the terms of the applicable lease agreements. Deferred rent is recorded when the cash rent received is lower than the straight-line revenue recognized. Such receivables decrease over the term of the applicable leases. Non-refundable maintenance reserves billed to lessees are accrued as maintenance reserves revenue based on aircraft usage. In instances where collectibility is not reasonably assured, the Company recognizes revenue as cash payments are received. The Company estimates and charges to income a provision for bad debts based on its experience in the business and with each specific customer, the level of past due accounts, and its analysis of the lessee s overall financial condition. If the financial condition of the Company s customers deteriorates, it could result in actual losses exceeding the estimated allowances. During 2010, due to uncertainty about the collectibility of the related receivables, the Company recorded $283,800 of bad debt expense related to maintenance paid on behalf of a lessee. In 2009, the Company recorded bad debt expense of $208,000 and reduced maintenance reserves revenue by $251,000, to reserve against amounts due from two lessees with which the Company had previously agreed to defer a portion of rent and reserves payments due during The Company also recorded bad debt expense of $1,300 in 2009 in connection with the return of an aircraft. Results of Operations The Company s net income decreased by $4,009,300 in 2010 compared to 2009, due primarily to decreased operating lease revenue and increased maintenance expense, the aggregate effect of which was partially offset by increased maintenance reserves revenue and decreased interest expense. 11

14 Operating lease revenue decreased by $4,279,700 in 2010 compared to 2009, primarily because of a $3,841,000 decrease in revenue related to aircraft that were off lease for all or part of 2010, a $737,000 decrease related to assets that were re-leased in 2010 at lower rates, and a $967,000 decrease due to uncertainty about the collectibility of certain receivables. The effects of these reductions were partially offset by a $478,000 increase in revenue related to aircraft engines purchased in the second half of 2009 and a $784,000 increase related to aircraft that were on lease in 2010, but were off lease in the 2009 period. Maintenance reserves revenue increased by $1,012,900 in 2010 compared to The 2010 period included maintenance reserves revenue of $3,263,300 related to refundable maintenance reserves retained by the Company when two aircraft were repossessed in early Such funds have been used for maintenance required by the return conditions of the leases. During 2010, the Company recorded a $494,600 reduction in maintenance reserves revenue due to uncertainty about the collectibility of the related receivables. Other income increased by $195,500 in 2010 compared to 2009, primarily because the 2010 period included a net gain on insurance proceeds that the Company received for one of its DHC aircraft that had sustained significant damage in January, as well as the sale of spare parts and an engine that was replaced on another of the Company s DHC aircraft. The 2009 period included interest on a federal tax refund, as well as a gain on expected insurance proceeds for damage to the Company s spare Saab 340A aircraft engine. The Company recognized $3,739,700 more in maintenance expense in 2010 than in The 2010 period included an increase in maintenance performed on aircraft that were returned to the Company during the year, which was funded primarily by reserves previously collected by the Company. This increase was partially offset by a year-toyear decrease in maintenance performed by lessees using non-refundable reserves and a decrease in maintenance performed on other off-lease aircraft. During 2010 and 2009, $8,577,000 and $3,375,100 respectively, of the Company s maintenance expense was funded by non-refundable maintenance reserves that had been recorded as revenue when earned. In 2010, two customers, which leased two Fokker 50 and three Fokker 100 aircraft, experienced severe financial difficulties and returned the five aircraft to the Company. One of the customers was a significant customer based on 2010 lease revenue. The Company retained all maintenance reserves, totaling $12,752,500 which were previously recorded as maintenance reserves revenue. The Company has incurred and will continue to incur significant maintenance costs in order to prepare the five aircraft for lease to new customers. Approximately $4,173,000 of such costs was incurred in The two customers referenced above were two of four customers with which the Company agreed to defer a portion of the rent and maintenance reserves due during 2009 and During 2010, the Company wrote off receivables, totaling approximately $938,000, owed by both customers at the time the aircraft were returned. Such write-offs resulted in reductions to the Company s operating lease revenue, maintenance reserves revenue and other income of $579,300, $344,800 and $13,900, respectively. Interest expense decreased by $903,800 in 2010 compared to 2009, primarily as a result of a lower average Subordinated Notes balance and lower discount amortization, as well as the expiration of the Company s interest rate swap in December The effects of these decreases were partially offset by an increase in the applicable LIBOR rate from year to year. In addition, the interest rate margin and fee amortization related to the Company s New Credit Facility were higher than under the Former Credit Facility. Professional fees and general and administrative expenses increased by $371,500 in 2010, compared to 2009, primarily because of legal expense incurred in 2010 in connection with the repossession of five aircraft. Insurance expense increased by $176,000 in 2010, compared to 2009, because more aircraft were off lease in The Company s effective tax rate was approximately 35% in the years ended December 31, 2010 and

15 Liquidity and Capital Resources The Company is currently financing its assets primarily through debt borrowings and excess cash flows. (a) Former Credit Facility and New Credit Facility During 2010, under the Former Credit Facility and New Credit Facility in the aggregate, the Company borrowed $13,000,000 and repaid $3,500,000 of the outstanding principal. As of December 31, 2010, and December 31, 2009, the Company was in compliance with all covenants under the New Credit Facility and Former Credit Facility agreements, respectively. On April 28, 2010, the Former Credit Facility expired after two short term-extensions, and the Company entered into the New Credit Facility. The Company used its initial borrowing under the New Credit Facility, which has a two-year term, to pay off the outstanding balance of $50,000,000 due under the Former Credit Facility at that time. As with the Former Credit Facility, the New Credit Facility is secured by all of the assets of the Company, including its aircraft and engine portfolio. The New Credit Facility is expandable on the addition of new participating lenders or increased participation by existing lenders to $110,000,000. It has a two-year term and provides for borrowing up to an amount equal to 75% of the value of the eligible collateral that secures the credit facility. Assets that are off lease in excess of four months or under lease but with payments in arrears by more than 30 days are excluded from the collateral base. The facility requires payments of interest only which floats at a rate equal to either LIBOR or the prime rate, plus a margin of 3.75%. The credit facility agreement requires the Company to maintain compliance with certain financial covenants related to (i) total debt to net worth; (ii) interest to net income; (iii) income to debt service; (iv) minimum tangible net worth; and (v) net losses. Any failure to maintain compliance with such covenants is deemed a default under the agreement. As of March 16, 2011, the Company had an outstanding balance of $63,000,000 under the New Credit Facility. Although the total maximum available credit under the New Credit Facility is $27,000,000, exclusion of certain aircraft, primarily off-lease, from the collateral base has decreased the maximum available credit to $328,000 at that date. The Company is currently in compliance with all covenants of its New Credit Facility, and based on its current projections, the Company believes it will continue to be in compliance with those covenants, but there can be no assurance of future compliance. The Company's interest expense in connection with the New Credit Facility will generally increase and decrease with prevailing interest rates. The Company s New Credit Facility has a fixed interest rate margin that is higher than the highest variable margin that was applicable to the Company s Former Credit Facility, but the Company does not anticipate that the higher margin will have a significant impact on the Company s results. The Company has the ability to enter into interest rate swaps to economically hedge against interest rate increases in its floating rate debt under the New Credit Facility and has done so in the past with respect to debt owed under the Former Credit Facility. (See Note 6 to the Company s financial statements and paragraph (b) below). (b) Derivative instrument In December 2007, the Company entered into a two-year interest rate swap (the Swap ) with a notional amount of $20 million, under which it committed to make or receive a net settlement for the difference in interest receivable computed monthly on the basis of 30-day LIBOR and interest payable monthly on the basis of a fixed rate of 4.04% per annum. The Company entered into the Swap with the objective of economically converting a portion of its floating rate debt into a fixed rate for the term of the Swap, thereby reducing the volatility of cash flow associated with its debt obligations. The Swap expired on December 31, 2009 and, therefore, had no value on or after that date. Gains and losses on the Swap were recorded as a component of interest expense. The Company recorded a gain on the Swap of $645,800 for 13